CFMS Reviewer PDF

Table of Contents: I. Capital Markets Stock Markets Equity Valuation Capital Structure II. Behavioral Finance Emotion and Investing Behavioral Finance and Investment Strategy Behavioral Finance and Capital Markets III. Interest...

Table of Contents: I. Capital Markets Stock Markets Equity Valuation Capital Structure II. Behavioral Finance Emotion and Investing Behavioral Finance and Investment Strategy Behavioral Finance and Capital Markets III. Interest Rates Interest Rate Determination Interest Rate Risk Interest Rate Derivatives Monetary Policy Yield Curve Inflation and Interest Rates IV. Income and Business Taxation Corporate Taxation Individual Taxation Tax Planning and Optimization V. Financial Analysis and Reporting Financial Statements Analysis Ratio Analysis Cash Flow Analysis Financial Modeling Financial Reporting and Disclosure VI. Banking and Financial Institutions Banking Regulation Risk Management in Banks Financial Institutions and Markets Bank Operations and Management VII. Fundamentals of Corporate Finance Capital Budgeting Cost of Capital Capital Structure Dividend Policy Mergers and Acquisitions Corporate Governance VIII. Bonds and their Valuation Bond Basics Bond Valuation Bond Yields and Prices Bond Risks  Fixed Income Portfolio Management IX. Investment and Portfolio Management Portfolio Theory Asset Allocation Security Analysis Investment Strategies Risk Management Performance Evaluation X. Cash and Working Capital Management Cash Flow Management Accounts Receivable and Payable Management Inventory Management Short-term Financing Working Capital Optimization Liquidity Management Disclaimer: This CFMS Reference and Review booklet is intended for educational and informational purposes only. While every effort has been made to ensure the accuracy, completeness, and reliability of the information provided, we do not guarantee or warrant the one percent accuracy or correctness of the content. The materials may contain errors, omission, or may have become outdated due to industry standards. The use of these materials does not create any form of a professional relationship between the reader and the authors or publishers. For the most updated information, please refer to official sources and relevant publications. While this will serve as a guide for your assessment examination, do not limit your review to this booklet. Use any available Finance-related books or references. Source: Available online and printed Finance-related books. I. CAPITAL MARKETS A. Stock Markets The stock market is where the prices of firms’ stocks are established. Because the primary goal of financial managers is to maximize their firms’ stock prices, knowledge of the stock market is important to anyone involved in managing a business. 2 Basic Types of Market Procedures: 1. Physical Location Stock Exchanges -​ Formal organizations having tangible physical locations that conduct auction markets in designated (“listed”) securities. -​ Physical location exchanges are tangible entities. Each of the larger exchanges occupies its own building, allows a limited number of people to trade on its floor, and has an elected governing body – its board of governors. 2. Over-The-Counter (OTC) - A large collection of brokers and dealers, connected electronically by telephones and computers, that provides for trading in unlisted securities. - Although the stocks of most large companies trade on the NYSE, a larger number of stocks trade o_ the exchange in what was traditionally referred to as the over- the-counter (OTC) market. Dealer Markets – A dealer market includes all facilities needed to conduct security transactions, but the transactions are not made on the physical location exchanges. The dealer market system consists of: 1. The relatively few dealers who hold inventories of these securities and who are said to "make a market" in these securities; 2. The thousands of brokers who act as agents in bringing the dealers together with investors; and 3. The computers, terminals, and electronic networks that provide a communication link between dealers and brokers. B. Equity Valuation The main purpose of equity valuation is to estimate the value of a firm or its security. A key assumption of any fundamental value technique is that the value of the security (in this case an equity or a stock) is driven by the fundamentals of the firm’s underlying business at the end of the day. There are a number of different methods of valuing a company with one of the primary ways being the comparable (or comparables) approach. ​ Comparables Approach  -​ A company’s equity value should bear some resemblance to other equities in a similar class. This entails comparing a company’s equity to competitors or other firms in the same sector. ​ Discounted Cash Flow -​ A company’s equity value is determined by the future cash flow projections using net present value. This approach is most useful if the company has strong data to support future operating forecasts. ​ Precedent Transactions -​ A company’s equity depends on historical prices for completed M&A transactions involving similar companies. This approach is only relevant if similar entities have been recently valued and/or sold. ​ Asset-Based Valuation -​ A company’s equity value is determined based on the fair market value of net assets owned by the company. This method is most often used for entities with a going concern, as this approach emphasizes outstanding liabilities determining net asset value. ​ Book-Value Approach -​ A company’s equity value is determined based on its previous acquisition cost. This method is only relevant for companies with minimal growth that might have undergone a recent acquisition. C. Capital Structure The term capital refers to investor-supplied funds—debt, preferred stock, common stock, and retained earnings. Accounts payable and accruals are not included in our definition of capital because they are not provided by investors—they come from suppliers, workers, and taxing authorities as a result of normal operations, not as investments by investors. A firm’s capital structure is typically defined as the percentage of each type of investor- supplied capital, with the total being 100%. The optimal capital structure is the mix of debt, preferred stock, and common equity that maximizes the stock’s intrinsic value. The capital structure that maximizes the intrinsic value also minimizes the weighted average cost of capital (WACC). II. BEHAVIORAL FINANCE Behavioral Finance is the study of various psychological factors that can a_ect financial markets. Behavioral finance typically encompasses five main concepts: ​ Mental accounting - Mental accounting refers to the propensity for people to allocate money for specific purposes.  ​ Herd behavior - Herd behavior states that people tend to mimic the financial behaviors of the majority of the herd. Herding is notorious in the stock market as the cause behind dramatic rallies and sell-offs. ​ Emotional gap - The emotional gap refers to decision-making based on extreme emotions or emotional strains such as anxiety, anger, fear, or excitement. Oftentimes, emotions are a key reason why people do not make rational choices. ​ Anchoring: Anchoring refers to attaching a spending level to a certain reference. Examples may include spending consistently based on a budget level or rationalizing spending based on different satisfaction utilities. ​ Self-attribution: This refers to a tendency to make choices based on overconfidence in one’s own knowledge or skill. Self-attribution usually stems from an intrinsic knack in a particular area. Within this category, individuals tend to rank their knowledge higher than others, even when it objectively falls short. A.​ Emotion and Investing -​ Some Biases Revealed by Behavioral Finance. Breaking down biases further, many individual biases and tendencies have been identified for behavioral finance analysis. Some of these include: -​ ​ Confirmation Bias -​ Confirmation bias is when investors have a bias toward accepting information that confirms their already-held belief in an investment. If information surfaces, investors accept it readily to confirm that they’re correct about their investment decision-even if the information is flawed. ​ Experiential Bias -​ This occurs when investors’ memory of recent events makes them biased or leads them to believe that the event is far more likely to occur again. For this reason, it is also known as recency bias or availability bias. ​ Loss Aversion -​ Loss aversion occurs when investors place a greater weighting on the concern for losses than the pleasure from market gains. In other words, they’re far more likely to try to assign a higher priority to avoiding losses than making investment gains. As a result, some investors might want a higher payout to compensate for losses. If the high payout isn’t likely, they might try to avoid losses altogether even if the investment’s risk is acceptable from a rational standpoint. ​ Familiarity Bias -​ The familiarity bias is when investors tend to invest in what they know, such as domestic companies of locally owned investments. As a result, investors are not diversified across multiple sectors and types of investments, which can reduce risk. Investors tend to go with investments that they have a history or have familiarity with. B. Behavioral Finance and Investment Strategy Market Timing and Technical Analysis -​ Asset bubbles and market crashes are largely a matter of timing. If you could anticipate a bubble and invest just before it began and divest just before it burst, you would get maximum return. That sort of precise timing, however, is nearly impossible to achieve. To time events precisely, you would constantly have to watch for new information, and even then, the information from di_erent sources may be contradictory, or there may be information available to others that you do not have. Taken together, your chances of profitably timing a bubble or crash are fairly slim. Market timing – an asset allocation strategy. C. Behavioral Finance and Capital Markets The efficient market hypothesis (EMH) says that at any given time in a highly liquid market, stock prices are efficiently valued to reflect all the available information. However, many studies have documented long-term historical phenomena in securities markets that contradict the efficient market hypothesis and cannot be captured plausibly in models based on perfect investor rationality. The EMH is generally based on the belief that market participants view stock prices rationally based on all current and future intrinsic and external factors. When studying the stock market, behavioral finance takes the view that markets are not fully efficient. This allows for the observation of how psychological and social factors can influence the buying and selling of stocks. III. INTEREST RATES Companies raise capital in two main forms: debt and equity. In a free economy, capital, like other items, is allocated through a market system, where funds are transferred and prices are established. The interest rate is the price that lenders receive, and borrowers pay for debt capital. Similarly, equity investors expect to receive dividends and capital gains, the sum of which represents the cost of equity. A. The Determinants of Market Interest Rates ​ The Real Risk-Free Rate of Interest, R* - the rate of interest that would exist on default-free US Treasury if no inflation were expected. ​ The Nominal, or Quoted, Risk-Free Rate of Interest – the rate of interest on a security that is free of all risk; rRF is proxied by the T-bill rate or the T-bond rate; rRF includes an inflation premium. ​ Inflation Premium (IP) – a premium equal to expected inflation that investors add to the real risk-free rate of return. ​ Default Risk Premium (DRP) – the di_erence between the interest rate on a US Treasury bond and a corporate bond of equal ​ Liquidity Premium (LP) – a premium added to the equilibrium interest rate on a security if that security cannot be converted to cash on short notice and at close to its “fair market value.”  ​ Interest Rate Risk – the risk of capital losses to which investors are exposed because of changing interest rates. ​ Maturity Rate Premium – a premium that reflects interest rate risk. ​ Reinvestment Rate Risk – the risk that a decline in interest rates will lead to lower income when bonds mature and funds are reinvested. The Cost of Money 4 Most Fundamental Factors A_ecting the Cost of Money: 1.​ Production Opportunities – The investment opportunities in productive (cash- generating) assets. 2.​ Time Preferences for Consumption – The preferences of consumers for current consumption as opposed to saving for future consumption. 3.​ Risk – In a financial market context, the chance that an investment will provide a low or negative return. 4.​ Inflation – The amount by which prices increase over time. People use money as a medium of exchange. When money is used, its value in the future, which is a_ected by inflation, comes into play. The higher the expected rate of inflation, the larger the required dollar return. Interest rate paid to savers depends on: (1) the rate of return that producers expect to earn on invested capital (2) savers’ time preferences for current versus future consumption (3) the riskiness of the loan, and (4) the expected future rate of inflation. Producers’ (borrowers) expected returns on their business investments set an upper limit to how much they can pay for savings, while consumers’ time preferences for consumption establish how much consumption they are willing to defer and hence how much they will save at different interest rates. Higher risk and higher inflation also lead to higher interest rates. Interest Rate Levels Short-term rates are responsive to current economic conditions. Long-term rates primarily reflect long-run expectations for inflation. Term Structure of Interest Rates – the relationship between long-term and short-term rates. Term Structure of Interest Rates -​ The relationship between bond yields and maturities. -​ It describes the relationship between long- and short-term rates. -​ The term structure is important to corporate treasurers deciding whether to borrow by issuing long- or short-term debt and to investors who are deciding where to buy long- or short-term bonds. Yield Curve – a graph showing the relationship between bond yields and maturities. Normal Yield Curve – an upward-slopping yield curve. Inverted (Abnormal) Yield Curve – a downward-slopping yield curve. Humped Yield Curve – a yield curve where interest rates on intermediate-term maturities are higher than rates on both short- and long-term maturities. B. Interest Rate Risk Interest Rate Risk – is the risk of capital losses to which investors are exposed because of changing interest rates. Maturity Risk Premium (MRP) – a premium that reflects interest rate risk. Reinvestment Rate Risk – the risk that a decline in interest rate will lead to lower income when bonds mature and funds are reinvested. C. Interest Rate Derivatives ​ The Real Risk-Free Rate of Interest, R* O Is the interest rate that would exist on a riskless security if no inflation were expected. It may be thought of as the rate of interest on short-term U.S. Treasury securities in an inflation-free world. The real risk-free rate is not static—it changes over time, depending on economic conditions, especially on (1) the rate of return that corporations and other borrowers expect to earn on productive assets and (2) people’s time preferences for current versus future consumption. Borrowers’ expected returns on real assets set an upper limit on how much borrowers can a_ord to pay for funds, whereas savers’ time preferences for consumption establish how much consumption savers will defer—hence, the amount of money they will lend at di_erent interest rates. ​ The Nominal, or Quoted, Risk-Free Rate of Interest, rRF = r* + IP O The rate of interest on a security that is free of all risk; rRF is proxied by the T-bill rate of the T-bond rate; rRF includes an inflation premium. O To be strictly correct, the risk-free rate should be the interest rate on a totally risk-free security—one that has no default risk, maturity risk, no liquidity risk, no risk of loss if inflation increases, and no risk of any other type. O If the term risk-free rate is used without the modifiers real or nominal, people ​ generally mean the quoted (or nominal) rate; and we follow that convention in this book. Therefore, when we use the term risk-free rate, rRF, we mean the nominal risk-free rate, which includes an inflation premium equal to the average expected inflation rate over the remaining life of the security. ​ Inflation Premium (IP) O A premium equal to expected inflation that investors add to the real risk free rate of return. ​ Default Risk Premium (DRP)  O The risk that a borrower will default, which means the borrower will not make scheduled interest or principal payments, also affects the market interest rate on a bond: The greater the bond’s risk of default, the higher the market rate. ​ Liquidity Premium (LP) O A “liquid” asset can be converted to cash quickly at a "fair market value." Real assets are generally less liquid than financial assets, but di_erent financial assets vary in their liquidity. Because they prefer assets that are more liquid, investors include a liquidity premium (LP) in the rates charged on different debt securities. D. Monetary Policy Monetary policy is a set of tools used by a nation’s central bank to control the overall money supply and promote economic growth and employ strategies such as revising interest rates and changing bank reserve requirements. Types of Monetary Policy ​ Contractionary – is a policy that increases interest rates and limits the outstanding money supply to slow growth and decrease inflation, where the prices of goods and services in an economy rise and reduce the purchasing power of money. ​ Expansionary – during times of slowdown or a recession, an expansionary policy grows economic activity. By lowering interest rates, saving becomes less attractive, and consumer spending and borrowing increase. ​ Goals of Monetary Policy Inflation - Contractionary monetary policy is used to temper inflation and reduce the level of money circulating in the economy. Expansionary monetary policy fosters inflationary pressure and increases the amount of money in circulation. ​ Unemployment - An expansionary monetary policy decreases unemployment as a higher money supply and attractive interest rates stimulate business activities and expansion of the job market. ​ Exchange Rates - The exchange rates between domestic and foreign currencies can be affected by monetary policy. With an increase in the money supply, the domestic currency becomes cheaper than its foreign exchange. Tools of Monetary Policy -​ Open Market Operations: In open market operations (OMO), the Federal Reserve Bank buys bonds from investors or sells additional bonds to investors to change the number of outstanding government securities and money available to the economy as a whole. The objective of OMOs is to adjust the level of reserve balances to manipulate the short-term interest rates and that a_ect other interest rates. -​ Interest Rates: The central bank may change the interest rates or the required collateral that it demands. In the U.S., this rate is known as the discount rate. Banks will loan more or less freely depending on this interest rate.  -​ Reserve Requirements: Authorities can manipulate the reserve requirements, the funds that banks must retain as a proportion of the deposits made by their customers to ensure that they can meet their liabilities. Lowering this reserve requirement releases more capital for the banks to o_er loans or buy other assets. Increasing the requirement curtails bank lending and slows growth. E. Yield Curve A graph showing the relationship between bond yields and maturities. The yield curve changes in position and in slope over time. o “Normal” Yield Curve – an upward-sloping yield curve. o Inverted (“Abnormal”) Yield Curve – a downward-sloping yield curve. o Humped Yield Curve – a yield curve where interest rates on intermediate-term maturities are higher than rates on both short- and long-term maturities. What Determines the Shape of the Yield Curve? Because maturity risk premiums are positive, if other things were held constant, long-term bonds would always have higher interest rates than short-term bonds. F. Inflation and Interest Rates ​ Interest rates tend to move in the same direction as inflation but with lags, because interest rates are the primary tool used by central banks to manage inflation. ​ In the U.S. the Federal Reserve targets an average inflation rate of 2% over time by setting a range of its benchmark federal funds rate, the interbank rate on overnight deposits. ​ Higher interest rates are generally a policy response to rising inflation. ​ Conversely, when inflation is falling and economic growth slowing, central banks may lower interest rates to stimulate the economy. How Changes in Interest Rates A_ect Inflation? In general, rising interest rates curb inflation while declining interest rates tend to speed inflation. When interest rates decline, consumers spend more as the cost of goods and services is cheaper because financing is cheaper. Increased consumer spending means an increase in demand and increases in demand increases prices. Conversely, when interest rates rise, consumer spending and demand decline, money-flows reverse, and inflation is somewhat tempered. How Do Interest Rates Affects ​ Stocks? In general, rising interest rates hurt the performance of stocks. If interest rates rise, that means individuals will see a higher return on their savings. This removes the need for individuals to take on added risk by investing in stocks, resulting in less demand for stocks. The Bottom Line Interest rates influence stocks, bond interest rates, consumer and business spending, inflation, and recessions. However, there is often a lag in the timing between an interest rate change and its effect on the economy. Some sectors may react quickly, such as the stock market, while the effect on other sectors such as mortgages and auto loans can take longer to be felt. By adjusting the federal funds rate, the Fed helps keep the economy in balance over the long term. Understanding the relationship between interest rates and the U.S. economy will allow investors to understand the big picture and make better investment decisions. Although the relationship between interest rates and the stock market is fairly indirect, the two tend to move in opposite directions. As a general rule of thumb, when the Federal Reserve cuts interest rates, it causes the stock market to go up; when the Federal Reserve raises interest rates, it causes the stock market to go down. But there is no guarantee as to how the market will react to any given interest rate change. INCOME AND BUSINESS TAXATION A.​ Corporate Taxation What is a Corporate Tax? -​ Corporate taxes are collected by the government as a source of income. It is based on taxable income after expenses have been deducted. Corporate Tax Deductions Corporations are permitted to reduce taxable income by certain necessary and ordinary business expenditures. All current expenses required for the operation of the business are fully tax-deductible. Investments and real estate purchased with the intent of generating income for the business are also deductible. A corporation can deduct employee salaries, health benefits, tuition reimbursement, and bonuses. In addition, a corporation can reduce its taxable income by deducting insurance premiums, travel expenses, bad debts, interest payments, sales taxes, fuel taxes, and excise taxes. Tax preparation fees, legal services, bookkeeping, and advertising costs can also be used to reduce business income. Special Considerations A central issue relating to corporate taxation is the concept of double taxation. Certain corporations are taxed on the taxable income of the company. If this net income is distributed to shareholders, these individuals are forced to pay individual income taxes on the dividends received. Instead, a business may register as an S corporation and have all income pass-through to the business owners. As S corporation does not pay corporate tax, as all taxes are paid through individual tax returns. Advantages of a Corporate Tax Paying corporate taxes can be more beneficial for business owners than paying additional individual income tax. Corporate tax returns deduct medical insurance for families as well as fringe benefits, including retirement plans and tax-deferred trusts. It is easier for a corporation to deduct losses, too. A corporation may deduct the entire amount of losses, while a sole proprietor must provide evidence regarding the intent to earn a profit before the losses can be deducted. Finally, profit earned by a corporation may be left within the corporation, allowing for tax planning and potential future tax advantages. The Bottom Line The corporate tax rate is a tax levied on a corporation's profits, collected by a government as a source of income. It applies to a company's income, which is revenue minus expenses. In the U.S., the federal corporate tax rate is a flat rate of 21%. States may also impose a separate corporate tax on companies. Companies often seek to lower their corporate tax obligations through taking advantage of deductions, loopholes, subsidies, and other practices. B. Individual Taxation Individual Income Tax Also referred to as personal income tax. This type of income tax is levied on an individual’s wages, salaries, and other types of income. This tax is usually a tax that the state imposes. Because of exemptions, deductions, and credits, most individuals do not pay taxes on all of their income. While a deduction can lower your taxable income and the tax rate used to calculate your tax, a tax credit reduces your income tax obligation. Tax credits help reduce the taxpayer’s tax obligation or amount owed. They were created primarily for middle- income and lower-income households. What Percent of Income is Taxed? The percent of your income that is taxed depends on how much you earn and your filing status. In theory, the more you earn, the more you pay. How Can I Calculate Income Tax? To calculate income tax, you’ll need to add up all sources of taxable income earned in a tax year. The next step is calculating your adjusted gross income (AGI). Once you have done this, subtract any deductions for which you are eligible from your AGI. The Bottom Line All taxpayers pay federal income tax. Depending on where you live, you may have to pay state and local income taxes, too. The U.S. has a progressive income tax system, which means that higher-income earners pay a higher tax rate than those with lower incomes. Most taxpayers do not pay taxes on all of their income, thanks to exemptions and deductions. C. Tax Planning and Optimization Tax planning is the analysis of a financial situation or plan to ensure that all elements work together to allow you to pay the lowest taxes possible. A plan that minimizes how much you pay in taxes is referred to as tax e_icient. Tax planning should be an essential part of an individual investor's financial plan. Reduction of tax liability and maximizing the ability to contribute to retirement plans are crucial for success. Tax planning covers several considerations. Considerations include timing of income, size, and timing of purchases, and planning for other expenditures. Also, the selection of investments and types of retirement plans must complement the tax filing status and deductions to create the best possible outcome. Tax Planning vs. Tax Gain-Loss Harvesting Tax gain-loss harvesting is another form of tax planning or management relating to investments. It is helpful because it can use a portfolio's losses to o_set overall capital gains. According to the IRS, short and long-term capital losses must first be used to o_set capital gains of the same type. In other words, long-term losses o_set long-term gains before offsetting short-term gains. Short-term capital gains, or earnings from assets owned for less than one year, are taxed at ordinary income rates. What Are Basic Tax Planning Strategies? Some of the most basic tax planning strategies include reducing your overall income, such as by contributing to retirement plans, making tax deductions, and taking advantage of tax credits. How Do High-Income Earners Reduce Taxes? There are many ways to reduce taxes that are not only available to high-income earners but to all earners. These include contributing to retirement accounts, contributing to health savings accounts (HSAs), investing in stocks with qualified dividends, buying muni bonds, and planning where you live based on favorable tax treatments of a specific state. The Bottom Line Tax planning involves utilizing strategies that lower the taxes that you need to pay. There are many legal ways in which to do this, such as utilizing retirement plans, holding on to investments for more than a year, and offsetting capital gains with capital losses. V. FINANCIAL ANALYSIS AND REPORTING A.​ Financial Statements Analysis Financial statement analysis is the process of analyzing a company’s financial statements for decision-making purposes. External stakeholders use it to understand the overall health of an organization and to evaluate financial performance and business value. Internal constituents use it as a monitoring tool for managing the finances.  How to Analyze Financial Statements The financial statements of a company record important financial data on every aspect of a business’s activities. As such, they can be evaluated on the basis of past, current, and projected performance. In general, financial statements are centered around generally accepted accounting principles (GAAP) in the United States. These principles require a company to create and maintain three main financial statements: the balance sheet, the income statement, and the cash flow statement. Public companies have stricter standards for financial statement reporting. Public companies must follow GAAP, which requires accrual accounting. Private companies have greater flexibility in their financial statement preparation and have the option to use either accrual or cash accounting. Several techniques are commonly used as part of financial statement analysis. Three of the most important techniques are horizontal analysis, vertical analysis, and ratio analysis. Horizontal analysis compares data horizontally, by analyzing values of line items across two or more years. Vertical analysis looks at the vertical e_ects that line items have on other parts of the business and the business’s proportions. Ratio analysis uses important ratio metrics to calculate statistical relationships. Types of Financial Statements Companies use the balance sheet, income statement, and cash flow statement to manage the operations of their business and to provide transparency to their stakeholders. All three statements are interconnected and create di_erent views of a company’s activities and performance. o Balance Sheet - The balance sheet is a report of a company’s financial worth in terms of book value. It is broken into three parts to include a company’s assets, liabilities, and shareholder equity. Short-term assets such as cash and accounts receivable can tell a lot about a company’s operational efficiency; liabilities include the company’s expense arrangements and the debt capital it is paying off; and shareholder equity includes details on equity capital investments and retained earnings from periodic net income. The balance sheet must balance assets and liabilities to equal shareholder equity. This figure is considered a company’s book value and serves as an important performance metric that increases or decreases with the financial activities of a company. o Income Statement - The income statement breaks down the revenue that a company earns against the expenses involved in its business to provide a bottom line, meaning the net profit or loss. The income statement is broken into three parts that help to analyze business efficiency at three different points. It begins with revenue and the direct costs associated with revenue to identify gross profit. It then moves to operating profit, which subtracts indirect expenses like marketing costs, general costs, and depreciation. Finally, after deducting interest and taxes, the net income is reached. Basic analysis of the income statement usually involves the calculation of gross profit margin, operating profit margin, and net profit margin, which each divide profit by revenue. Profit margin helps to show where company costs are low or high at different points of the operations. o Cash Flow Statement - The cash flow statement provides an overview of the company’s cash flows from operating activities, investing activities, and financing activities. Net income is carried over to the cash flow statement, where it is included as the top line item for operating activities. Like its title, investing activities include cash flows involved with firm-wide investments. The financing activities section includes cash flow from both debt and equity financing. The bottom line shows how much cash a company has available. o Free Cash Flow and Other Valuation Statements - Companies and analysts also use free cash flow statements and other valuation statements to analyze the value of a company. Free cash flow statements arrive at a net present value by discounting the free cash flow that a company is estimated to generate over time. Private companies may keep a valuation statement as they progress toward potentially going public. o Financial Performance - Financial statements are maintained by companies daily and used internally for business management. In general, both internal and external stakeholders use the same corporate finance methodologies for maintaining business activities and evaluating overall financial performance. When doing comprehensive financial statement analysis, analysts typically use multiple years of data to facilitate horizontal analysis. Each financial statement is also analyzed with vertical analysis to understand how di_erent categories of the statement are influencing results. Finally, ratio analysis can be used to isolate some performance metrics in each statement and bring together data points across statements collectively. Below is a breakdown of some of the most common ratio metrics: ​ Balance sheet: This includes asset turnover, quick ratio, receivables turnover, days to sales, debt to assets, and debt to equity. ​ Income Statement: This includes gross profit margin, operating profit margin, net profit margin, tax ratio e_iciency, and interest coverage. ​ Cash flow: This includes cash and earnings before interest, taxes, depreciation, and amortization (EBITDA). These metrics may be shown on a per-share basis. ​ Comprehensive: This includes return on assets (ROA) and return on equity (ROE), along with DuPont analysis. What are the advantages of financial statement analysis? The main point of financial statement analysis is to evaluate a company’s performance or value through a company’s balance sheet, income statement, or statement of cash flows. By using a number of techniques, such as horizontal, vertical, or ratio analysis, investors may develop a more nuanced picture of a company’s financial profile. What are the different types of financial statement analysis? Most often, analysts will use three main techniques for analyzing a company’s financial statements.  ​ First, horizontal analysis involves comparing historical data. Usually, the purpose of horizontal analysis is to detect growth trends across di_erent time periods. ​ Second, vertical analysis compares items on a financial statement in relation to each other. For instance, an expense item could be expressed as a percentage of company sales. ​ Finally, ratio analysis, a central part of fundamental equity analysis, compares line-item data. Price-to-earnings (P/E) ratios, earnings per share, or dividend yield are examples of ratio analysis. What is an example of financial statement analysis? An analyst may first look at a number of ratios on a company’s income statement to determine how efficiently it generates profits and shareholder value. For instance, gross profit margin will show the di_erence between revenues and the cost of goods sold. If the company has a higher gross profit margin than its competitors, this may indicate a positive sign for the company. At the same time, the analyst may observe that the gross profit margin has been increasing over nine fiscal periods, applying a horizontal analysis to the company’s operating trends. B. Ratio Analysis Ratios help us evaluate financial statements. For example, at the end of 2015, Allied Food Products had $860 million of interest-bearing debt and interest charges of $88 million, while Midwest Products had $52 million of interest-bearing debt and interest charges of $4 million. Which company is stronger? The burden of these debts and the companies' ability to repay them can best be evaluated by comparing each firm's total debt to its total capital and comparing interest expense to the income and cash available to pay that interest. Ratios are used to make such comparisons. We calculate Allied's ratios for 2015 using data from the balance sheets and income statements given in Tables 3.1 and 3.2. We also evaluate the ratios relative to food industry averages, using data in millions of dollars.' As you will see, we can calculate many different ratios, with di_erent ones used to examine di_erent aspects of the firm's operations. You will get to know some ratios by name, but it's better to understand what they are designed to do than to memorize names and equations. We divide the ratios into five categories. 1. Liquidity ratios, which give an idea of the firm's ability to pay o_ debts that are maturing within a year.